Unitec
Institute of Technology
Assignment 2
Referring to the course
ALAF630: The Economics of Money and Financial Markets

Risk in Financial Markets & Monetary Policy in New Zealand

Semester One 2001

Name: Thomas Kramer

Handed in to: Beverley Moodie
Deadline: 1st Mai 2000

Table of contents

1 Risk in Financial Markets ... 1
1.1 Asymmetric Information ... 1
1.2 Transaction Costs ... 4

2 Monetary Policy ... 5
2.1 The Role of Monetary Policy in an Economy ... 5
2.2 The Operation of Monetary Policy in New Zealand ... 6
2.3 The "Best Practice" in Monetary Policy ... 8
2.4 New Zealand′s Approach in Comparison to other Countries ... 10
2.5 Concerns and Recommendations ... 13

3 References ... 17

1 Risk in Financial Markets

Risk in financial markets becomes a major issue regarding financial transactions between parties in the market. "Risk in finance relates to the uncertainty of both the amount and timing of the future cash flows of a business or project". (Anonymous, no year)

It occurs when financial decisions have to be made with an amount of uncertainty about the pay-off of the financial transaction. This is because of insufficient knowledge about the other party involved in the transaction, which is called incomplete or asymmetric information. This lack of information makes it difficult to decide accurately and creates a problem on two fronts, before and after the transaction. (Mishkin, 2001, p. 34-35, 187)

1.1 Asymmetric Information

Adverse Selection is the problem created by asymmetric information that occurs before the transaction is initiated. It means that a potential borrower seeks out a loan but knows for himself that the outcome of his investment is most likely to be undesirable (adverse) for the lender. Due to the fact that these people are the ones who most actively seek out loans the probability is therefore very high that these will be selected. Since this problem leads to loans that may base on bad credit risks the lender is more likely not to make a loan even though if there might be a good credit risk available. (Mishkin, 2001, p. 35)

Countermeasures to avoid the problem of adverse selection exist. An option is to sell information about the businesses to people who want to supply them with their funds in order to minimize the inequality in information. But as soon as information is sold, other people not paying for the information will benefit from it as well and will adjust their actions according to it too, eliminating any profit for the original purchaser of the information. This problem is called free-rider problem; as a result only little information is produced due to this problem. (Mishkin, 2001, p. 189)

The government can reduce the problem of adverse selection if it either produces information about the businesses itself or provides incentives for businesses to reveal honest information about themselves, so that investors can distinguish between bad and good firms. But government regulations do not eliminate the problem since businesses will make themselves appear to be a good company even though they might not be one. (Mishkin, 2001, p. 189-190)

In terms of financial intermediaries government allows only particular trustworthy institutes to enter the market in order to guarantee effective financial transactions. These intermediaries become experts in screening out good from bad credit risks, thereby reducing the loss of adverse selection. They then acquire funds (private non-traded loans) from depositors and lend them to good firms. Since the bank lends mostly to good firms, the return of the investments is so high that it is feasible to pay interests to the depositor and continue engaging in information production activity. As a result the financial intermediaries can lower the risk of ineffective financial transactions due to adverse selection and free-riding. (Mishkin, 2001, p. 37, 190-191)

The second front based on asymmetric information that bears a significant risk to financial transaction is the problem called moral hazard. It occurs after a transaction is made and describes the risk (hazard) that the borrower hides information or uses the money for activities that are undesirable from the lender′s point of view because these activities make it less likely to be able to repay the loan. Due to this reason lenders may decide not to make a loan. (Mishkin, 2001, p. 36)

Moral hazard has significant consequences when firms raise funds with equity contracts. This consequence is the principal-agent problem that arises because of a lack of information and control what is done with the funds by the different equity-owner parties after the transaction. A small minority party may take advantage of this lack of information and uses the funds according to its self-interests rather than the interests of the whole business. (Mishkin, 2001, p. 192-193)

Countermeasure to defeat the principal-agent problem is the production of information (monitoring), but since it is costly in terms of money and time it makes equity contracts less desirable for financial transactions. Government regulation can help forcing companies to particular standards and thus making profit verification easier. But this is considered to be not that effective since there are still enough loopholes where people can make it hard for the government to find or prove fraud. (Mishkin, 2001, p. 194)

Financial intermediaries again can avoid the principal-agent as well as the moral hazard problem. These institutes verify and watch the firms′ activities they have financial transactions with, having their own people as members in the firms′ managing body. Since they claim non-tradable equity in the firm they provided with funds, they avoid the free-rider problem as well because nobody else can benefit from the firm′s monitoring activities. (Mishkin, 2001, p. 194)

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